Understanding A Firm s Financial Statements

Transcription

1 CHAPTER OUTLINE Spotlight: J&S Construction Company ( 1 The Lemonade Kids Financial statement (accounting statements) reports of a firm s financial performance and resources, including an income statement, a balance sheet, and a cash flow statement Setting Up the Business determining firm s assets and sources of financing Opening Day developing alternate methods of payment rather than cash Collecting Accounts Receivable Strategic Planning for the Following Saturday The Second Saturday of Business 2 The Income Statement Describe the purpose and content of an income statement. Definitions Income statement (profit and loss statement) a financial report showing the profits or losses from a firm s operations over a given period of time Cost of goods sold cost of producing or acquiring goods or service to be sold by a firm Gross profit sales less the cost of goods sold Operating expenses costs related to marketing and selling a firm s product or service, general and administrative expenses, and depreciation Operating profits earnings after operating expenses but before interest and taxes are paid Interest expense the cost of borrowed money Profits before taxes (taxable profits) earnings after operating expenses and interest expenses but before taxes Net profits earnings that may be distributed to the owners or reinvested in the company Depreciation expense cost of a firm s building and equipment, allocated over their useful life Profit margins Profits as a percentage of sales Answers question, How profitable is the business? Reports sales (revenue), cost of producing or acquiring the goods or services sold by the company, operating expenses, interest expense, tax payments Allows business owner to consider how decision affect the company s profits 3 The Balance Sheet Explain the purpose and content of a balance sheet. Formula Total assets = Debt + Ownership equity Assets Definitions Current assets assets that can be converted into cash relatively quickly 102

2 Accounts receivable amount of credit extended to customers that is currently outstanding Inventory firm s raw materials and products held in anticipation of eventual sale Working capital cycle the process of converting inventory to cash Fixed assets (property, plant and equipment [PPE]) Physical assets that will be used in the business for more than one year, such as equipment, buildings, and land. Depreciable assets assets whose value declines, or depreciates, over time Gross fixed assets Depreciable cost at their original cost before any depreciating expense has been taken. Accumulated depreciation total (cumulative) depreciation expense taken over the assets life Net fixed assets gross fixed assets less accumulated depreciation Other assets A firm s raw materials and products held in anticipation of eventual sale. These are all things owned by the business Debt and Equity Debt financing provided by creditors Current debt (short-term liabilities) borrowed money that must be repaid within 12 months Accounts payable (also called trade credit) Outstanding credit payable to suppliers. Accrued expenses Operating expenses that have been incurred but not paid. Short-term notes Agreements to repay cash amounts borrowed from banks or other lending sources within 12 months or less Long-term debt loans from banks or other sources with repayment terms of more than 12 months. Long-term notes Agreements to repay cash amounts borrowed from banks or other lending sources for periods longer than 12 months Ownership Equity Mortgage a long term loan from a creditor for which real estate is pledged as collateral Ownership equity owners investments in a company plus cumulative net profits retained in the firm Retained earnings profits less less dividends paid over the life of a business 4 Viewing the Income Statement and Balance Sheet Together How do financial statements how a firm s financial position? Balance sheet is a view of the firm s financial condition at a particular point in time Income statement shows results over a given period (a quarter or a year for example) 5 The Cash Flow Statement Use the income statement and balance sheets to compute a company s cash flows. Profits versus Cash Flows 103

3 Cash flow statement a financial report showing a firm s sources of cash as well as its uses of cash Accrual-basis accounting an accounting method of recording profits when earned and expenses when incurred, whether or not the profit has or the expense paid Cash-basis accounting an accounting method of recording profits when cash is received and recording expenses when they are paid Profits based on an accrual accounting system will differ from the firm s cash flows Sales reported in an income statement include both case sales and credit sales; total sales do not correspond to the actual case collected Some inventory purchases are financed by credit, so inventory purchases do not exactly equal cash spent for inventory Depreciation expense shown in the income statement is a noncash expense Measuring a Firm s Cash Flows Cash inflows and outflows explained by three activities Generating cash flows from day-to-day business operations Buying or selling fixed assets Financing the business Cash Flows From Day-To-Day Business Operations Converts the company s income statement from an accrual basis to a cash basis Two steps required Add back depreciation to net profits, since depreciation is not a cash expense Subtracting any uncollected sales and payments for inventory Investing in Fixed Assets equipment or buildings (example) Financing the Business 6 Evaluating a Firm s Financial Performance Analyze the financial statements using ratios to see how well a firm is doing Entrepreneur s decisions basically in four areas Firm s ability to pay its debt as it comes due Company s profitability from assets Amount of debt the business is using Rate of return earned by the owners on their equity investment Pendley & Associates Liquidity (Ability to Pay Its Debt) Definitions Liquidity the degree to which a firm has working capital available to meet maturing debt obligations Current ratio a measure of a company s relative liquidity, determined by dividing current assets by current liabilities Pendley & Associates Profitability on Its Assets 104

4 Return on assets a measure of a firm s profitability relative to the amount of its assets, determined by dividing operating profits by total assets (see Exhibit 10-9 Return on Assets: An Overview) Definitions Operating profit margin a measure of how well a firm is controlling its costs of goods sold and operating expenses relative to sales, determined by dividing operating profits by sales Total asset turnover a measure of how efficiently a firm is using its assets to generate sales, calculated by dividing sales by total assets Pendley & Associates Debt debt ratio is a measure of what percentage of a firm s assets is financed by debt, determined by dividing total debt by total assets Pendley & Associates Return on Equity Return on equity a measure of the rate of return owners receive on their equity investment, calculated by dividing net profits by ownership equity Financial leverage the impact (positive or negative) of financing with debt rather than with equity. A firm with a high (low) return on assets will have a high (low) return on equity As a firm s debt ration increases, return on equity will increase if the return on assets is greater than the interest rate paid on any debt, but return on equity will decrease if the return on assets is less than the interest rate ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 1. Explain the purposes of the income statement and balance sheets? The income statement reports the results of periodic operations, detailing sales revenue, cost of goods sold, selling expenses, administrative expenses, interest expense, and other income and expenses. It culminates in a bottom line statement of net profit (or loss). The balance sheet is the statement that details and classifies the firm s various assets and liabilities and the ownership equity in the business. Total assets always equal the sum of liabilities and ownership equity. The final net profit (or loss) shown on the income statement adjusts the value of the ownership equity reported on the balance sheet. 2. What determines a company s profitability? A company s profit is a primary source of financing for future growth. The more profitable a company is, the more funds it will have for growth. Thus, we need to know the factors that drive profits so that we can make the needed profit projections. A company s net income, or net profit, depends on four variables: Amount of sales. Much that we project about a company s financial future is driven by the assumptions we make regarding future sales. Costs of goods sold. This reflects the cost of producing or acquiring the goods or services to be sold. 105

5 Operating expenses. Operating expenses include expenses such as those related to marketing and distributing the product. We want, as best we can, to classify these expenses as either expenses that do not vary as sales increase or decrease (fixed operating expenses) or expenses that change proportionally with sales (variable operating expenses). Interest expense. When we borrow money, we agree to pay interest on the loan principal. If we borrow $25,000 for a full year and commit to paying 12-percent interest, our interest expense will be $3,000 for the year (12% $25,000). Taxes. For the most part, the firm s taxes are a percentage of taxable income. The rate increases as the amount of income increases. 3. Distinguish among (a) gross profit, (b) operating profits, and (c) net profits. a. Gross profit is sales (revenue) less the cost of producing or acquiring the product or service. It is the difference between what the product costs the producer and what the producer sells it for. b. Operating profits are determined by deducting operating expenses and depreciation expense from gross profit. c. Net profits are the income that may be distributed to the owners or reinvested in the company. 4. The balance sheet reports information on a firm s (1) assets, (2) debt, and (3) equity. What is included in each of these reported categories? Assets include everything owned by the company. Assets are basically divided in current assets (assets that can be converted into cash relatively quickly), fixed assets (assets that take much longer to convert into cash), and other assets (such as patents, copyrights, and goodwill). Debt is financing provided by a creditor and is divided into current (short-term) debt that must be repaid within 12 months and long-term debt that includes loans from banks or other sources that are generally loaned for longer than 12 months (for example, for a mortgage). Equity is money that the owners invest in the business as well as the cumulative amount of profits that have been retained in the business. 5. How are ownership equity and debt different? Ownership equity is the money invested in a firm by the owners (including stockholders) for use in conducting the business. Debt is the money loaned to a business that establishes a debtor-creditor relationship. 6. Distinguish between common stock and retained earnings. Common stock is an investment in the firm while retained earnings are profits less withdrawals (dividends) over the life of a business. 106

6 7. What is the relationship between an income statement and a balance sheet? The income statement reports the results of periodic operations, detailing sales revenue, cost of goods sold, selling expenses, administrative expenses, interest expense, and other income and expenses. It culminates in a bottom line statement of net profit (or loss). The balance sheet is the statement that details and classifies the firm s various assets and liabilities and the ownership equity in the business. Total assets always equal the sum of liabilities and ownership equity. The final net profit (or loss) shown on the income statement adjusts the value of the ownership equity reported on the balance sheet. 8. Why aren t a firm s cash flows equal to its profits? The cash flow statement shows a firm s sources of cash as well as its uses of cash indicating where cash came from and went to in a business. Profits are the result of an increase in cash that is created by spending less than what is earned by the business through sales of products/services. 9. Describe the three major components of a cash flow statement. The three major components of a cash flow statement are the net profits less depreciation, and cost of products/services sold. 10. What questions do financial ratios help answer about a firm s financial performance? Financial ratios restate selected income statement and balance sheet data to provide information that helps the management of a venture compare how it is doing relative to previous periods of time in the company and how it is doing compared to other ventures within the same industry. 107

7 COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 1. What did Donahoo s balance sheet look like at the outset of the firm s life? Balance Sheet Date Assets Assets Debt + Equity Debt + Equity 1-Jan Plus $1,500 Cash $1,500 Debt $ 500 Plus $500 y Equit 1,000 Plus $1,000 Total $1,500 Total $1, What did the firm s balance sheet look like after each transaction? Date Assets Assets Debt + Equity Debt + Equity 2-Jan Cash $1,000 Accts payable $ 500 Less $500 Inventory 1,000 Debt 500 Plus $500 Plus $1,000 Total $2,000 Equity 1,000 Total $2,

8 Assets Assets Debt + Equity Debt + Equity 3-Jan Cash $1,000 Payables $ 500 Plus $250 Receivables 250 Debt 500 Less $200 Inventory 800 Equity 1,050 Plus $50 Plus $50 $2,050 $2,050 Date Assets Assets Debt + Equity Debt + Equity 15-Jan Cash $1,000 Payables $ 700 Receivables 250 Debt 500 Plus $200 Plus $200 Inventory 1,000 Equity 1,050 $2,250 $2,250 Assets Assets Debt + Equity Debt + Equity 31-Jan Cash sale: + $50 Reduce debt: - $250 Dividend: - $100 Total cash - $300 Payables $ 700 Cash $ 700 Debt 250 Equity 1,050 Plus $50 $2,000 Plus $450 Receivables

9 Less $400 Inventory 600 $2, Ignoring taxes, determine how much income Donahoo earned during January. Prepare an income statement for the month. Recognize an interest expense of 1 percent for the month (12 percent annually) on the $500,000 long-term debt, which has not been paid but is owed. January 3 January 31 Jan 1 Jan 31 Revenues $ 250 $ 500 $ 750 Cost of goods sold (200) (400) (600) Gross profits/operating profits Interest expense (1%/month) $ 50 $ 100 $ (5) Net Income $ 50 $ 100 $ What was Donahoo s cash flow for the month of January? Beginning cash (January 1) $ 1,50 0 Ending cash (January 31) 700 Net change in cash $ (800 ) Free cash flow Operating Perspective Operating income $ 150 Depreciation Expense --- EBITDA $

10 current assets Cash $ (800) Accounts 700 receivable Inventory 600 $ 500 current assets accounts 700 payable net working $ (200) capital Free cash flow (operating) $ 350 Free cash flows Financing perspective Dividends $ 100 Debt retirement 250 Interest expense $ 5 accounts (5) payable Interest paid --- Free cash flow $

11 Situation 2 1. Given the information provided by the financial statements, what would you tell Abrahams? (As part of your answer, calculate the firm's cash flows.) Explain to Ms. Abrahams that his equation for determining cash flows (profits + depreciation), although correct once in a while, can be very misleading. The cash flows can be better determined as follows: Firm s cash flows: Operating income $19,000 Depreciation 5,000 Earnings before interest, taxes, and depreciation $24,000 Cash taxes 8,000 After-tax cash flows from operations $16,000 net working capital: current assets $10,000 non-interest bearing short-term debt 3,000 net working capital $7,000 Investment in fixed assets ($5,000) Decrease in other assets 2,000 Firm s cash flows: $6,000 Financing cash flows: Interest $3,000 Dividends 3,000 Financing cash flows $6,000 Thus, the Turpen Company generated $6,000 in cash flows, which were used to pay dividends and interest to investors. Also, we should notice that of the $6,000 that was paid to investors, $2,000 came from a reduction in cash balances. If the cash had not been reduced, there would have been only $4,000 available to the investors. In short, there is no money available for Rose. 2. How would you describe the cash flow pattern for the Turpen Company? The primary sources of cash are (a) income plus depreciation (a noncash charge) and (b) increasing short-term borrowings in the form of accounts payable and accruals. The primary uses are (a) increased investments in accounts receivable, inventories, and fixed assets and (b) payment of dividends. 112

12 Situation 3 1. Compute the financial ratios discussed in the chapter for Wholesome Foods for 2010 and Current ratio Return on assets 19.6% 17.9% Operating profit margin 13.3% 13.1% Total asset turnover Debt ratio 55.1% 56.7% Return on equity 23.4% 20.9% Calculations: Current ratio 138,300/75, ,000/84,400 Return on assets 80,000/408,300 85,000/475,000 Operating profit margin 80,000/600,000 80,000/650,000 Total asset turnover 600,000/408, ,000/475,000 Debt ratio 225,000/408, ,400/475,000 Return on equity 42,900/183,300 43,000/205, Acquire a small firm s financial statements. Review the statements and describe the firm s financial position. Find our if the owner agrees with your conclusions Answers will vary. This would also require either bringing some financial statements to class and having the students review them or, assuming wifi is available in the classroom, having students pull up this information on their laptops and then evaluating the financial data. 3. Interpret your findings, both for the firm s financial ratios compared to those of the peer group and for the cash flow statement. Answers will vary depending on the chosen firm s financial ratios. 113

13 SUGGESTED SOLUTION TO CASE 10: DIETRICH & MERCER, INC. 1. How would you evaluate the company s liquidity? Liquidity is the degree to which a firm has working capital available to meet maturing debt obligations. To assess the company s ability to pay its current liabilities, several computations can be done to make this determination: Assess working capital which is use to evaluate a company ability to pay current liabilities, Compute the current ratio, which is a more reliable indicator of the ability to pay current liabilities than working capital. Compute the quick ratio, which considers current assets, unlike the other two computations. 2. Assess the company s historical performance in generating operating profits on its assets Return on Assets (Operating Profits / Total Assets) was 11.4% $2,766,000 / $24,267, Return on Assets was 10.4% ($2,868,000 / $27,434,000) In 2011 assets increased and profits decreased. Additional analysis could include computing the company s debt ratio to measure what percentage of the firm s assets if financed by debt (determined by dividing total debt by total assets). 3. Describe how the business is financed. The business is financed with both debt and equity. Via debt they have a $2.3m note to the bank, $4.4m of credit via accounts payable, and $8.1m long-term debt. Via equity they have $2.08 of common stock and additional paid-in-capital and $8.2m in retained earnings. 4. Do Dietrich and Mercer receive a good return on their equity investment in the business? Return of equity is a measure of the rate of return that owners receive on their equity investment calculate by dividing net profits by ownership equity Return on equity was 11.4% ($1,044,000 / $9,136,000) 2011 Return on equity was 10.3% ($1,063,000 / 10,291,000) Because they had a lower return on assets in 2011, it stands that they will have a lower return on equity in It simply is not possible to have a good return on equity if you are not earning a good return on your assets. Also, as the amount of the firm s debt increases, its return on equity will increase provided that the return on assets is higher than the interest rate paid on any debt. 114